Lecture 8:

Quantitative Option Strategies

Marco Avellaneda
G63.2936.001

Spring Semester 2009

 Equity Options Markets

• Single-name options

Electronic trading in 6 exchanges, cross-listing of many stocks, penny-wide

bid ask spreads for many contracts

• Index Options

S&P 500, NDX, Minis. Traded on the Chicago Mercantile Exchange. VIX options
& futures trade in CME as well.

• ETF Options

Most of the large ETFs are optionable. Traded like stocks in multiple exchanges.
SPY, QQQQ, XLF are among the most traded options in the US.
 Options Markets
Halliburton (HAL) April 09
CALLS PUTS
Symbol Last Change Bid Ask Volume Open Int Strike Symbol Last Change Bid Ask Volume Open Int
HALDA.X 12.65 0 11.15 11.3 0 0 5 HALPA.X 0.03 0 N/A 0.04 100 210
HALDU.X 8.5 0 8.65 8.85 2 2 7.5 HALPU.X 0.05 0 0.01 0.06 1 2,237
HALDB.X 5.2 0 6.3 6.35 57 116 10 HALPB.X 0.15 0 0.1 0.12 25 3,775
HALDZ.X 4.2 0.15 4.05 4.15 20 944 12.5 HALPZ.X 0.4 0.12 0.39 0.4 185 10,482
HALDC.X 2.31 0.1 2.3 2.33 220 4,942 15 HALPC.X 1.06 0.33 1.09 1.11 52 10,592
HALDP.X 1.11 0.18 1.09 1.11 495 8,044 17.5 HALPP.X 2.42 0.34 2.36 2.37 196 8,482
HALDD.X 0.43 0.05 0.42 0.44 57 10,693 20 HALPD.X 4.59 0 4.15 4.25 250 12,440
HALDQ.X 0.15 0.02 0.14 0.16 23 7,646 22.5 HALPQ.X 7.25 0 6.4 6.45 25 2,770
HALDE.X 0.05 0.01 0.05 0.06 13 4,060 25 HALPE.X 9.95 0 8.8 8.85 4 1,111
HALDR.X 0.03 0 0.01 0.03 8 5,784 27.5 HALPR.X 12.35 0 11.25 11.35 18 977
HALDF.X 0.01 0 N/A 0.02 20 8,399 30 HALPF.X 14.8 0 13.7 13.9 18 5,772
HALDS.X 0.04 0 N/A 0.04 1 1,698 32.5 HALPS.X 15.5 0 16.2 16.4 20 150
HALDG.X 0.08 0 N/A 0.04 2 1,470 35 HALPG.X 18.93 0 18.7 18.9 5 514
HALDT.X 0.02 0 N/A 0.04 9 604 37.5 HALPT.X 20.59 0 21.2 21.35 40 151
HALDH.X 0.02 0 N/A 0.03 10 1,593 40 HALPH.X 20.6 0 23.7 23.85 10 139
HALDV.X 0.02 0 N/A 0.02 4 2,805 42.5 HALPV.X 26.1 0 26.2 26.4 752 311
HALDI.X 0.02 0 N/A 0.02 1 623 45 HALPI.X 28.6 0 28.7 29 152 0
HALDW.X 0.02 0 N/A 0.02 1 245 47.5 HALPW.X 31.1 0 31.2 31.4 52 13
HALDJ.X 0.02 0 N/A 0.02 7 733 50 HALPJ.X 24.55 0 33.7 33.9 0 0
HALDX.X 0.04 0 N/A 0.02 10 324 52.5 HALPX.X 14.8 0 36.2 36.4 0 0
HALDK.X 0.02 0 N/A 0.02 10 376 55 HALPK.X 19.1 0 38.7 39 0

HAL= $16.36
Available expirations: Mar09, Apr09, Jul09, Oct09, Jan10, Jan11
2 front months, 2 LEAPS, quarterly cycle (Jan cycle for HAL).
 Put-Call Parity
C − P = Se − dT − Ke − rT
Put-call parity holds for American options which are ATM, to within
reasonable approximation.

CALLS PUTS (C-P+K*(1-r*40/252))/S d_imp

HALDC.X 2.3 2.33 15 H ALPC.X 1.09 1.11 0.988473167 7.26%
HALDP.X 1.09 1.11 17.5 H ALPP.X 2.36 2.37 0.989451906 6.65%

Hal pays dividend of 9 cents at the end of Feb, May, Aug, Nov

There are no ex-dividend dates between now and April 20, 2009.

Option markets give an implied cost of carry for the stock (implied forward price),
which may be different from the nominal cost of carry. This is due to stock-loan
considerations.
 DIA Options Apr 18, 2009
Symbol Last Change Bid Ask Volume Open Int STRIKE Symbol Last Change Bid Ask Volume Open Int
DIHDX.X N/A 0 18.1 18.2 0 0 50 DIHPX.X 0.37 0 0.15 0.19 18 245
DIHDY.X 21 0 17.3 17.4 2 2 51 DIHPY.X 0.39 0 0.17 0.22 105 370
DIHDZ.X 16.3 0 16.3 16.4 1 93 52 DIHPZ.X 0.26 0.22 0.23 0.26 7 225
DIHDA.X N/A 0 15.45 15.55 0 0 53 DIHPA.X 0.32 0.26 0.28 0.31 5 68
DIHDB.X N/A 0 14.25 14.35 0 0 54 DIHPB.X 0.4 0.24 0.34 0.37 4 392
DIHDC.X 11.94 0 13.45 13.55 4 14 55 DIHPC.X 0.42 0.38 0.41 0.44 25 765
DIHDD.X 12.35 0.17 12.55 12.65 40 22 56 DIHPD.X 0.51 0.46 0.49 0.52 20 870
DIHDE.X 10.3 0.47 11.6 11.75 10 48 57 DIHPE.X 0.61 0.53 0.59 0.62 72 414
DIHDF.X 8.6 0 10.75 10.85 2 202 58 DIHPF.X 0.73 0.53 0.71 0.73 32 689
DIHDG.X 8.4 0 9.85 9.95 33 211 59 DIHPG.X 0.86 0.54 0.83 0.87 18 658
DIHDH.X 8.4 1.35 9 9.1 48 206 60 DIHPH.X 1 0.75 1 1.02 165 11,734
DIJDI.X 7.7 1.22 8.15 8.3 1 162 61 DIJPI.X 1.21 0.75 1.17 1.2 61 510
DIJDJ.X 7.2 0.8 7.4 7.45 34 228 62 DIJPJ.X 1.43 0.9 1.38 1.4 41 916
DIJDK.X 6.7 1.65 6.6 6.7 137 282 63 DIJPK.X 1.65 0.94 1.61 1.63 108 1,347
DIJDL.X 6 1.6 5.9 5.95 60 444 64 DIJPL.X 1.93 1.03 1.89 1.91 305 1,138
DIJDM.X 5.25 1.41 5.2 5.25 102 825 65 DIJPM.X 2.27 1.18 2.19 2.21 583 1,735
DIJDN.X 4.55 1.32 4.5 4.6 69 1,142 66 DIJPN.X 2.64 1.21 2.52 2.56 213 1,919
DIJDO.X 3.96 1.25 3.9 4 134 945 67 DIJPO.X 3.05 1.4 2.91 2.95 450 2,115
DIJDP.X 3.4 1.08 3.35 3.4 343 1,788 68 DIJPP.X 3.46 1.44 3.3 3.4 217 2,505
DIJDQ.X 2.85 0.91 2.84 2.87 168 1,709 69 DIJPQ.X 3.8 1.85 3.8 3.9 116 1,688
DIJDR.X 2.41 0.82 2.37 2.4 399 9,896 70 DIJPR.X 4.54 1.61 4.35 4.4 144 2,829
DIJDS.X 1.92 0.64 1.94 1.98 117 1,465 71 DIJPS.X 5.14 1.86 4.9 5 51 3,035
DIJDT.X 1.58 0.58 1.57 1.6 262 1,998 72 DIJPT.X 5.6 2.2 5.55 5.65 7 2,528
DIJDU.X 1.27 0.5 1.25 1.29 215 1,924 73 DIJPU.X 6.28 2.37 6.2 6.35 22 1,580
DIJDV.X 1 0.4 0.99 1.02 235 1,761 74 DIJPV.X 7.1 2.05 6.95 7.05 2 1,253
DIJDW.X 0.78 0.3 0.77 0.79 182 3,421 75 DIJPW.X 7.8 2.28 7.75 7.85 29 1,292
DIJDX.X 0.6 0.16 0.58 0.61 26 2,652 76 DIJPX.X 10.3 0 8.55 8.65 29 1,008
DIJDY.X 0.44 0.14 0.44 0.47 27 2,055 77 DIJPY.X 9.5 2.36 9.4 9.5 5 943
DIJDZ.X 0.32 0.05 0.32 0.35 81 1,800 78 DIJPZ.X 10.65 0.75 10.3 10.4 4 1,290
DIJDA.X 0.26 0.09 0.24 0.26 140 1,147 79 DIJPA.X 11.83 1.37 11.2 11.3 3 1,006
DIJDB.X 0.19 0.08 0.17 0.2 48 8,568 80 DIJPB.X 13.57 1.29 12.15 12.25 3 1,352
DIJDC.X 0.11 0 0.12 0.15 9 3,494 81 DIJPC.X 15.13 0 13.1 13.2 26 5,989
DAVDD.X 0.1 0 0.09 0.12 92 2,455 82 DAVPD.X 16.6 0 14.3 14.45 10 1,184
DAVDE.X 0.07 0.01 0.06 0.09 3 3,218 83 DAVPE.X 16.44 1.22 15.3 15.4 1 1,016
DAVDF.X 0.05 0 0.05 0.08 23 1,470 84 DAVPF.X 16.85 1.28 16.3 16.4 3 843
DAVDG.X 0.04 0 0.03 0.07 11 4,203 85 DAVPG.X 17.2 1.55 17.3 17.4 30 496
DAVDH.X 0.02 0 0.02 0.06 3 841 86 DAVPH.X 17.7 0 18.25 18.4 1 91
DAVDI.X 0.04 0 N/A 0.05 10 617 87 DAVPI.X 21.78 0 19.25 19.35 3 305
DAVDJ.X 0.04 0 N/A 0.05 8 748 88 DAVPJ.X 19.5 0 20.25 20.35 10 124
DAVDK.X 0.04 0.01 N/A 0.04 30 450 89 DAVPK.X 15.9 0 21.25 21.35 15 56
DAVDL.X 0.04 0 N/A 0.04 30 927 90 DAVPL.X 16.95 0 22.2 22.35 5 58
DAVDM.X 0.03 0 N/A 0.04 4 787 91 DAVPM.X 17.5 0 23.2 23.35 2 78
 Implied Dividend Yield for DIA
April 18, 2009 Options

CALLS PUTS (C-P+K*(1-r*40/252))/S d_imp

DIJDP.X 3.35 3.4 68 DIJPP.X 3.3 3.4 0.995267636 2.98%
DIJDQ.X 2.84 2.87 69 DIJPQ.X 3.8 3.9 0.994951292 3.18%

Dividend Yield from Yahoo.com= 3.30%

Actual payments are approx 15 cents / month ~ $1.80 ~ 2.60%

Step1 in understanding options markets: find the implied dividend from the market.

If the implied dividend is different from the nominal dividend then

-- check for HTB if d imp > d nom

-- check for dividend reductions if d imp < d nom

Calculation of d_{nom}, d_{imp}

 n

 S − ∑ Di e −rTi  Dividend payment
−1  
dates
d nom = ln i =1
T  S 
 
 

− 1  Catm − Patm + K atm e −rT 

d imp = ln 
T  S 
 Implied Volatility
HAL April 09
CALLS PUTS
Symbol Last Bi d Ask IVOL Delta Strike Symbol Last Bid Ask IVOL Del ta
HALDU.X 8.5 8.65 8.85 na 1.00 7.5 HALPU .X 0.05 0.01 0.06 211 0.00
HALDB.X 5.2 6.3 6.35 141 0.99 10 HALPB.X 0.15 0.1 0.12 144 -0.01
HALDZ.X 4.2 4.05 4.15 108 0.94 12.5 HALPZ.X 0.4 0.39 0.4 109 -0.05
HALDC.X 2.31 2.3 2.33 92.4 0.76 15 HALPC .X 1.06 1.09 1.11 93 -0.24
HALDP.X 1.11 1.09 1.11 85.1 0.36 17.5 HALPP.X 2.42 2.36 2.37 85 -0.63
HALDD.X 0.43 0.42 0.44 82.4 0.09 20 HALPD .X 4.59 4.15 4.25 84 -0.90
HALDQ.X 0.15 0.14 0.16 89.3 0.02 22.5 HALPQ.X 7.25 6.4 6.45 90 -0.97

250

200
Implied Volatility

150 CALLS

100 PUTS

50

0
7.5 10 12.5 15 17.5 20 22.5
Strike
 DIA Volatility Surface, March 10 2009, 12:00 noon
DIA, Mar09 DIA, Jun 30, 09
50 39
48 38
46 37
44 36
42
35 call call
40
34 put put
38
36 33
34 32
32 31
30 30
64 65 66 67 68 69 70 71 72 73 64 65 66 67 68 69 70 71 72 73

DIA, Apr09 DIA, Sep 30, 09

42 37

36
40
35
38
34 call call
36
33 put put
34
32
32
31
30 30
64 65 66 67 68 69 70 71 72 73
64 65 66 67 68 69 70 71 72 73

These curves move and provide trading opportunities.

Many different trades possible

-- Carry trades using options (implied dividend vs. actual dividend, HTB)

-- Volatility surface trades (non-directional): trading different strikes on

the same underlying asset

-- historical vol vs implied vol

-- Relative-value trades across names (non-directional)

-- single-name option versus fair-value

-- dispersion trading (index option versus components)

-- Directional volatility trades (long vol/ short vol, etc)

 Skewness
-- For equities, the implied volatility curve is decreasing in the strike
price around ATM

-- The effect is more pronounced for indices and etfs than for single names
 Mechanics of option trading
-- Open position (long or short) and trade the stock so as to be
delta-neutral.
-- Adjust the Delta of the option as the stock/option prices move

∂C ∂C ∂C 1 ∂ 2C 2
dC = dt + dS + dσ + dS + ...
∂t ∂S ∂σ 2 ∂S 2

P & L ≈ dC − ∆dS + ∆Srdt − ∆Sddt − rCdt

 ∂C  ∂C S 2 ∂ 2C  dS 2 
= − ∆ dS + dσ + 
2 
− σ 2
dt 
 ∂S  ∂σ 2 ∂S  S 2

 ∂C 
− − ∆  S (r − d )dt
 ∂S 
 ∂C S 2σ 2 ∂ 2C ∂C 
+  + + (r − d ) S − rC dt
 ∂t 2 ∂S ∂S
2

∂C S 2 ∂ 2C  dS 2 
≈ dσ +  2 − σ dt 
2 
2

∂σ 2 ∂S  S 
 Book-keeping: profit/loss
from a delta-hedged option position

( )
P/L = θ ⋅ n 2 − 1 + V ⋅ dσ

or

1  (dI ) 
2
P/L = Γ ⋅  2 − σ dt  + V ⋅ dσ
2

2  I 
1-day P/L for Long Call/Short Stock
(Constant volatility=16%)
50

40

30

20

10

0
950 975 1000 1025 1050 1075 1100 1125 1150 1175 1200 1225 1250 1275

-10

P/L ≈ θ ⋅ (n 2 − 1)

percent index change

θ = daily time - decay , n =
expected daily volatility
 Assuming an implied
volatility drop of 1%
Vol=15%

50

40

30

20

10

0
950 975 1000 1025 1050 1075 1100 1125 1150 1175 1200 1225 1250 1275

-10

3.80 loss if stock does not move

and volatility drops 1%
 A closer look at the profit-loss
due to a change in volatility
6

0
1075 1100 1125 1150 1175
-1

-2

-3

-4

-5

1% move in vol => 8% move in premium for a 6m ATM option

 Measuring the Risk of a Portfolio
(assuming delta neutrality)
Portfolio of options on N stocks
nij contracts of option with underlying
stock i , expiration T j , volatility σ ij

 ∂Cij 
∆Π = ∑ nij  C (S i + ∆S i , T j , K ij , σ ij + ∆σ ij ) − C (S i , T j , K ij , σ ij ) − ∆Si 
ij  ∂S i 

( ( ))
= ∑ nij  C Si (1 + R , T j , K ij , σ ij 1 + R − C (S i , T j , K ij , σ ij ) −
Si σ ij ∂Cij
∂S i

S i R Si 
ij  

Need to define a joint distribution of stock returns and volatility returns to

calculate statistics of PNL
 Factor Model
Consider only parallel vol shifts and use 30-day ATM volatilities
m
R = ∑ β ik Fk + ε i
Si

k =1
m
R = ∑ γ ik Fk + ς i
σi

k =1

Extract factors from PCA of augmented matrix

σj σj
Cij = R Si R , Dij = R Si R , Eij = Rσ i R
Sj

 C D
M =   M ∈ R 2 N ×2 N
 D' E 
Alternative Approach using ETFs

dσ i dSi dσ ETF (i )
= βi +γi + ςi,
σi Si σ ETF (i )
ETF (i ) = ETF associated with stock i

Model the ATM volatility returns as a function of the stock return and
changes in the volatility of the sector.

Conjecture: there are fewer systematic factors that explain volatility

returns than in the case of stock returns. (m<20)

Possible project: do the PCA on the Nasdaq 100 optionable stocks

analyzing the matrix M for this case.
 Modeling the Volatility Skew
x = ln( K / S )

σ imp ( x, t ) = σ imp (0, t ) ⋅ (1 + γx + δx 2 + ...)

Proposition: Under reasonable assumptions on price process (stoch. vol),

dσ atm dS
If =β +ε
σ atm S

β
Then γ=
2
Evolution of the slope of the 30-day implied
volatility curve, 1996-2004

Avellaneda & Lee, 2005

Evolution of ratio [slope/leverage coefficient]
The ``roaring 90’s’’!

Fair value line (SV) γ = β / 2

Avellaneda & Lee, 2005